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Part 6: Technical Analysis Signal Basics
Reversals occur both in traditional price formations and in candlestick indicators. Traditional reversals often occur at or close to resistance and support and may be found in many forms. There are many, but four are especially strong:
1. Head and shoulders. This pattern has three parts. All are tops. The first and third are the shoulders, and the middle, higher top is the head. After the pattern shows up, price is expected to retreat. The shoulders may approach or even touch resistance, and the head may break through. This is a very strong bearish reversal signal. An example is shown in the chart of Altria (MO) in figure 2.7. In the first month, the chart shows a weakening uptrend, clearly marked with the shoulders and the head, and then a reversal occurred and led to an extended downtrend. The opposite is called the inverse head and shoulders. In this pattern, bottoms replace the tops, and the head may break through support. When this occurs, it is a strong bullish signal. For example, as shown in figure 2.8, Apple (AAPL) ended its downtrend with an inverse head and shoulders and then immediately reversed into an uptrend.
2. Double bottom or top. Double tests of support (double bottom) or resistance (double top) are very common and also may represent a momentary breakthrough and retreat. Once the double test fails, price tends to move in the opposite direction. Dell provided an example of both (fig. 2.9). The double bottom marked the conclusion of the downtrend and was followed by a brief uptrend. The double top was prominent with consecutive violations of resistance, a downward gap, and then a strong reversal and downtrend.
3. Price gaps. Technicians know that gaps occur often, so distinguishing between common gaps (with no special signalling value) and meaningful gaps (runaway, breakout, and exhaustion) requires careful study and confirmation. The chart of JC Penney (JCP) in figure 2.10 includes examples of several gapping price patterns. The first three could be interpreted as runaway gaps as the uptrend began. However, prices declined briefly before resuming. In this pattern, the fourth gap—which was a strong move—may have provided confirmation of the uptrend’s continuation. The last gap followed a doji session with an unusually long upper shadow, a strong sign that buyer momentum was gone. This exhaustion gap marked the end of the uptrend and the beginning of a reversal.
4. Triangles. Figure 2.2 provided an example of the rising triangle form of reversal, in this case for 3M. Two additional types of triangles are also found in charts. The falling triangle is a bullish reversal, and an example is found in the chart of Coca-Cola (KO) in figure 2.11. The brief but strong uptrend evolved into sideways movement, but the falling triangle was strong evidence that prices would reverse and move down, which is what they did.
The symmetrical triangle (also called a coil) is characterized by a falling resistance and rising support at the same time. As the triangle narrows, a new trend (or resumption of a previous trend) follows. The symmetrical triangle is the most difficult to interpret because it can indicate either continuation or reversal. For example, as shown in figure 2.12, McDonald’s (MCD) began with an uptrend and then moved into the symmetrical pattern. Because price gapped lower after conclusion of the triangle, the initial indication was of a downtrend. However, the price moved upward in a delayed resumption of the previous uptrend.
For swing traders, these many different technical signals are valuable in determining the timing for entry and exit. In addition to the price-specific indicators, another area worth tracking is volume. Besides the volume spike, you should also look for popular volume indicators including on-balance volume (OBV) and accumulation/distribution (A/D), both of which measure the dominance of either buyers or sellers as trends evolve.
A final type of traditional analysis is the use of momentum oscillators. These are calculated measurements of the direction of a trend as well as of its speed and strength. As trends come to their end, momentum tends to fall, often anticipating price reversal. Momentum is a powerful form of confirmation, and examples in coming chapters demonstrate how timing based on oscillators can be fine-tuned effectively.
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